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Watch: Despite the rate cut, is EPF still your best bet for retirement?
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If the rate continues to decline, your retirement corpus will not be as big as you might have thought at one time. Inflation will further erode the purchasing power of the accumulated corpus. If anything, this rate cut should nudge investors out of complacency. Some of them may need to go back to the drawing board and revisit their retirement planning. This week’s cover story tells you how much returns to realistically expect from your EPF, and what supplementary investments may be needed to ensure a comfortable retirement.
Post EPF interest rate cut, can you fund retirement with these investments?
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EPF rate has declined in past 20 years
But the rate changes in EPF have been less volatile than in government-backed small savings schemes.
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Despite the 40 bps rate cut, the PF remains a solid retirement vehicle. The 8.1% interest is higher than what other comparable fixed income instruments offer. The interest earned on contributions up to Rs 2.5 lakh a year is tax-free. The PPF, which is comparable on tax benefits, fetches a much lower rate at 7.1% (see table). Kalpesh Ashar, Founder, Full Circle Financial Planners, observes, “The EPF remains a boon for the salaried class. It offers a full 1 percentage point more than the PPF, which also has an investment cap of Rs 1.5 lakh a year.”
Suresh Sadagopan, Founder, Ladder7 Investment Advisories, exhorts investors not to get anchored to earlier rates. “The previous rate of 8.5% was unrealistic given what comparable instruments were offering. Even the revised rate is artificially higher.” He further points out that the volatility in EPF rates is still considerably lesser than that seen in other instruments.
EPF still gives highest return
Even after the rate cut, the EPF interest rate is several notches above what other comparable fixed income instruments offer.
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Only PPF gives higher returns
Though PPF gives higher returns, there is also an annual investment limit of Rs 1.5 lakh in the scheme.
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Abhishek Gupta, Founder and Chief Financial Planner, Moat Wealth, asserts, “EPF provides the earliest savings discipline for most, acting like a regular SIP towards your retirement corpus.” Besides forcing individuals into the savings habit, the EPF ensures that the contributions keep rising because the contribution is linked to the basic salary. This facet of the PF is critical in building a sizeable corpus.
However, to make the most of the EPF, one should stay the course until retirement and refrain from premature withdrawals. Often, contributors dip into the EPF corpus to fund other goals. The essence of the EPF lies in letting the power of compounding (earning interest on interest) do its magic over the long term. If allowed to grow, the EPF can yield a bountiful harvest.
Rework the retirement math
Nevertheless, the cut in the EPF rate threatens to disrupt your retirement calculations. Here is an example: At the earlier rate of 8.5%, a 30-year old salaried employee with a basic monthly salary of Rs 30,000 would have a corpus of Rs 1.91 crore at the age of 60. This assumes a 5% yearly rise in contributions. At the revised interest rate of 8.1%, the corpus shrinks by about 6.5% to Rs 1.8 crore.
However, these calculations assume the interest rate will remain constant, whereas it is likely to move down in the coming years. Dev Ashish, Founder, Stable Investor, argues, “If the historical interest rate trajectory is any indication, then the EPF rate will go down even further in the years to come and may not even beat inflation.” So your corpus at retirement may be lower than what you may have projected. Assuming EPF interest rates reduce by 0.1% every year—touching 5.1% in another 30 years—the final corpus would be only Rs 1.31 crore—32% lower than what was originally projected at 8.5%.
Your EPF could be smaller than projected
If interest rate is cut further, the corpus projected at 8.5% will not be achieved.
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VPF remains a viable option
EPFO rules allow subscribers to make additional contributions to the PF account via the Voluntary Provident Fund. An individual can contribute up to 100% of the basic salary to the PF. Till last year, it fetched the same returns and enjoyed the same tax benefits. But from the last financial year, interest from contributions beyond Rs 2.5 lakh a year will be fully taxed. This reduces the post-tax returns for investors in the high tax brackets.
Even so, planners insist that VPF still continues to be a good tool to enhance one’s retirement corpus. Hiking your EPF contribution may seem counterintuitive given the cut in interest rates. But it offers great value for conservative investors. Sadagopan avers, “There is no case for diluting contributions to the VPF. No other instrument in this risk profile yields the same return.”
A higher contribution can also compensate for the rate cut. Even if you put only 5% more of your basic pay in the VPF, it can greatly enhance your retirement corpus. If a 30-year old with a basic salary of Rs 30,000 puts another 5% via the VPF every month, his final EPF corpus will be nearly Rs 30 lakh bigger (see graphic).
Contributing more via VPF can bolster your EPF corpus
If the total contribution to EPF exceeds Rs 2.5 lakh in a year, the interest will be taxed.
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Despite tax, VPF a good option
Only interest on contributions beyond Rs 2.5 lakh in a year will be taxed. The post-tax return is still quite high.
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Before you binge on VPF, find out how much more you can invest without breaching the Rs 2.5 lakh tax-free ceiling. Most individuals will have enough room to hike EPF contributions without hitting the tax threshold. For instance, a person earning a monthly basic pay of Rs 40,000 (Rs 4.8 lakh a year) mandatorily contributes Rs 57,600 a year to the EPF. He can additionally park up to Rs 1,92,400 in the EPF account by putting Rs 16,033 every month via the VPF.
To be sure, contributions beyond Rs 2.5 lakh do not necessarily make EPF tax-inefficient. Only the interest earned on contributions above Rs 2.5 lakh a year will be taxed at the slab rate. The effective tax on the entire contribution still gives VPF the edge over other fixed-income instruments. For instance, an EPF contribution of Rs 3 lakh a year will effectively yield a post-tax return of 7.7% for someone in the 30% tax bracket. Even if you hike contribution to Rs 4 lakh a year, the effective yield remains a healthy 7.15%—still higher than PPF. The new tax on EPF starts pinching for contributions beyond this level. Note that PPF has upper investment limit of Rs 1.5 lakh a year. For contributions beyond this limit, VPF is the best bet. Vivek Rege, Founder, VR Wealth Advisors, says, “In the absence of other risk-free options, conservative investors can continue VPF beyond Rs 2.5 lakh as tax impact up to a point is very low.”
Diversify beyond PF
However, experts warn against bingeing on fixed income. The EPF is predominantly a debt instrument, with only 15% of fresh inflows allowed to be invested in equities. The modest exposure to equities may not help the corpus earn high returns. Most advisors suggest investors should restrict the EPF contribution to Rs 2.5 lakh and invest the rest in equity-linked vehicles. “You need to augment EPF contributions with an asset that provides inflation-beating returns in the long run,” contends Ashish.
Equities are the only asset class with the potential to generate inflation-beating returns in the long term. To give you a perspective, the EPFO itself has earned 14.67% annualised returns on its Rs 1.23 lakh crore investment in equity ETFs as on 31 March 2021. If your retirement is 15-20 years away, the returns from equities could be significantly higher than what the EPF can offer. While the returns will not be linear and guaranteed, the opportunity cost of not taking risks in such a long-term horizon is too high to ignore. Rege insists, “If you have the risk appetite and sufficient time in hand for retirement, move to market-linked instruments to build a healthy corpus.” Supplement your EPF contributions with investments in the NPS or equity-oriented mutual funds.
Supplement EPF with equity investments
Find out how much more you need to invest after factoring in likely PF corpus
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But subscribers must choose their asset mix very carefully. Assuming you are already contributing to PF, your NPS asset mix should have a high-equity bias initially. In this regard, ‘auto choice’ mode can get restrictive as it starts diluting equity exposure very early. Whatever your risk profile, the exposure starts coming down from age 36. Even for a subscriber who opts for ‘aggressive’ option for higher equity exposure, the allocation reduces sharply from 75% up to age 35 to 55% by the time she hits 40 and further to 35% by age 45. Comparatively, the Active choice option allows the subscriber to park 75% in equities till age 50. Gupta remarks, “Even if you have a long time horizon, the first 10 years of contributions are the most crucial. The compounding in later years will be maximum on this initial capital.” Interestingly, the NPS allows subscribers to continue contributions well into retirement—up to the age of 75. This is unlike the EPF which forces withdrawal upon retirement. The flexibility to extend NPS beyond the age of 60 allows the subscriber to benefit from uninterrupted compounding.
NPS Auto choice is restrictive
The exposure to equities comes down sharply as you grow older
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NPS Active investors can invest more in equities
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The retirement scheme helps you save tax in three different ways.
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In contrast, the investor can diversify across multiple fund managers when investing via traditional equity or hybrid mutual funds. “By investing via mutual funds, you can design your own retirement portfolio. You tell the product what to do and not the other way round,” says Rege. If you seek regular income post-retirement, the systematic withdrawal plan of a mutual fund can give a fixed payout while allowing your capital to grow. It is also a more tax-efficient way of drawing regular income.
Regardless of your choice of vehicle, make sure your retirement portfolio is well balanced between equities and fixed income. While too much of fixed income can dilute returns, not everyone can take higher risk. Ashar asserts, “Maintain a prudent mix and not be overexposed to either end of the spectrum.” Sadagopan remarks, “Do not rock the boat too much in a bid to compensate for lower return in the PF. Stick to the asset allocation that your risk tolerance allows.”
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